Insolvency and Corporate Governance – Some Initial Observations on the Government Response

10 Sep 2018

As has been well covered in the media, the Government has recently published its response to consultations to reform aspects of insolvency law and corporate governance. A great deal of thought has clearly gone into developing its reform proposals, including those concerning the creation of a new moratorium period for financially distressed (but ultimately viable) companies. The Government has signaled its intention to bring forward legislation as soon as parliamentary time permits.

Taken as a whole, the proposed reforms should – with some caveats – result in a much improved legislative framework, whilst mindful that, when it comes to financially distressed businesses, there is unlikely to be a “perfect” outcome, but more frequently “less bad” ones, particularly when viewed against the prism of jobs and impact upon creditors.

Some initial observations on certain specific aspects of the Government’s response are as follows:-

Gateway to moratorium

In its consultation on the Corporate Insolvency Framework published in May 2016, the Government proposed (at para 7.7) that the restructuring moratorium would act “as a single[emphasis added] gateway to different forms of restructuring including a compromise with creditors, a contractual/consensual workout, a CVA, administration or a scheme of arrangement”.

The desirability of introducing a single gateway was underlined by the April 2017 judgment in JCAM Commercial Real Estate Property XV Limited v Davis Haulage Limited [2017] EWCA Civ 267 in which the Court of Appeal held that giving a notice of intention to appoint an administrator (thereby giving rise to an interim moratorium) was impermissible without a settled intention to appoint an administrator, rather than the appointment being one of several possible options (e.g. – a proposal for the approval of a company voluntary arrangement (CVA)).

Yet the Government’s response does not use the expression “single gateway”, rather referring (at para 5.124) to “introducing the proposals as a standalone procedure”. Given the important legal consequences necessitating a financially distressed company to embark on the correct form of moratorium at the outset (as underlined by the JCAM –v- Davis case), it would be helpful for the Government to clarify whether it intends to maintain notices of intention to appoint an administrator to continue to run alongside the proposed new moratorium, or abolish notices of intention to appoint.

Test for entry to moratorium

The Government has stated (at para 5.28) that “the test for entry into a moratorium should exclude companies that are already insolvent” on the grounds that “a moratorium could be mis-used by directors to delay an inevitable insolvency, increasing creditor losses in the process”.

However (at para 5.22), the Government stated that “a pending winding-up petition, the outcome of which is yet to be determined by the court” should not be a bar to obtaining a moratorium.

Perhaps surprisingly, the word “insolvent” is not itself defined in the Insolvency Act 1986; rather, the Act talks in terms of “a company is deemed unable to pay its debts” (section 123), “gone into insolvent liquidation” (section 214) or “onset of insolvency” (section 240).

The Government’s response would be clearer (and make more sense) if at para 5.28 it referred to formal insolvency (i.e. – administration, liquidation or CVA), in which event that company would be under the control of a licensed (and regulated) insolvency practitioner and the potential mischief of misuse of the moratorium procedure by directors would thereby be avoided. It would be helpful if the Government clarified that aspect of its response. The risk is that, otherwise, any lack of clarity as to whether a company is or is not “insolvent” so as to be excluded from entering into a moratorium could result in costly and time consuming legal proceedings to resolve that issue and undermine the prospect of returning the company to financial health.

Termination clauses

The Government’s response states (at para 5.97) that it “will legislate to prohibit the enforcement of ‘termination clauses’ by a supplier in contracts for the supply of goods and services where the clause allows a contract to be terminated on the ground that one of the parties to the contract has entered formal insolvency”; this prohibition will also apply to a company that is subject to the pre-insolvency moratorium process outlined above or a restructuring plan process. However (at para 5.99) “Suppliers will retain the ability to terminate contracts on any other ground permitted by the contract.”

There is however some confusion attaching to this proposal, given that the Government intends that a moratorium is a pre-insolvency event (paras 5.62 and 5.75) and a debtor-in-possession process (para 5.40) with the company continuing to operate its business, in contrast to an administration or liquidation where an insolvency office-holder takes control of the debtor’s assets and affairs.

It is therefore not clear why the Government states (at para 5.104) that it “does not, however, think that licences issued by public authorities should be affected and there may be legitimate public policy grounds for revoking such licences on the insolvency of a company, which should be allowed to take effect. Existing rules relating to particular licensing regimes will therefore remain unaltered.”

Indeed, this is where the Government’s response (regrettably) displays muddle-headed thinking; if the company is continuing to operate its business (and is otherwise complying with the terms of its licence), then the prohibition on the enforcement of termination (or ‘ipso facto’) clauses should also apply to licences issued by a public authority.

If a company is unable to trade during a moratorium (or administration) due to the termination of a licence that it requires in order to lawfully carry on its business, then the prospect of successfully rescuing that company is likely to be negligible.

That would be unfortunate and would run the risk of the proposed reforms being a damp squib, similar to the much critcised (and virtually unused) Schedule A1 moratorium which the Government intends to repeal (see para 5.14).

The need to get this aspect of the reforms right is fundamental to their success; termination of licences when a company enters an insolvency process (or “pre-insolvency event” in the case of the proposed moratorium) is frequently the reason why a company rescue cannot proceed; see JCAM –v- Davis where David Richards LJ stated at para 24:-

“…the company had the benefit of haulage operating licences which an administrator would not be able to hold, so that the business would not be able to continue to trade in an administration.”

It is to be hoped that the Government will reconsider its position by bringing licences issued by public authorities into line with its proposals concerning contractual licences.

Value extraction schemes

The Government’s intention to work with stakeholders to make it easier for office-holders to challenge preferential payments to connected creditors and to bring forward legislation to tackle this is welcomed.

As part of these consultations, it is to be hoped that the resulting legislation will encourage the collaboration between office-holders and unconnected creditors to bring legal proceedings (where justified) for recovery of assets and to share in the rewards of a successful recovery, in much the same way that Australian insolvency legislation (section 564 of the Corporations Act and its predecessors) has worked well there for more than 120 years; see for example the Babcock & Brown case. Bringing in a suitable mechanism to encourage creditors to work together with insolvency practitioners to challenge wrongful conduct on the part of directors and others will help deter such conduct, improve accountability and corporate governance and advance the Government’s transparency agenda.

Conclusion

The overall assessment of the Government’s response is that it is – for the most part – welcome and well-considered. As the Government prepares to embark on the parliamentary process in turning its proposals into legislation, it is to be hoped that it will continue to take on board constructive criticism – detailed both above and elsewhere – to help it achieve its objective for a new approach to how Government and business can work together to shape a stronger economy and avoid the disappointing weaknesses that have bedeviled the unlamented (and soon to be late) Schedule A1.

For more information on any of the above or, how we can help your business, please contact Neil Harrold, or call 0191 232 8345.

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